The economics and politics of instability, empire, and energy, with a focus on Latin America and the Caribbean, plus other random blather and my wonderful wonderful wife. And I’d like a cigar right now.

July 23, 2012

Keystone and U.S. oil markets

One new thing in oil markets is the persistant breach between the price of West Texas Intermediate (WTI) and Brent, ranging between $8 and $27. At the same time, the differential between Louisiana Light Sweet and Brent has remained under $3.

Why is that? Well, the answer is that American production has boomed in places like North Dakota. The price of WTI is actually set in Oklahoma (just to confuse you) and it is hard to get oil in large quantity from Oklahoma to the coast for export.Louisiana crude, on the other hand, is right there on the coast. As a result, the shale oil boom in the Dakotas (and to a lesser extent booming oil sand production from Alberta) causes crude to pile up in the Midwest, depressing prices relative to the coasts.

So who benefits? If the lower prices of Midwestern crude are passed on to Midwestern consumers, then they should oppose the Keystone pipeline. After all, Keystone will only make it easier to export oil to the coasts, where prices are higher. On the other hand, if the benefits of cheaper crude are not passed on, then consumers in the Midwest have few direct self-interested reasons to oppose it, at least in the short run. (They may, of course, have other valid reasons not to like the pipeline.)

Severin Borenstein of the Haas School of Business and Ryan Kellogg of the University of Michigan decided to take a look at this question. What did they find? Simply put: Midwestern refineries are running at capacity and can’t satisfy Midwestern demand. As a result, gasoline needs to be imported from the East Coast ... where crude is more expensive. Wholesale refined product prices, therefore, are not any cheaper in the Midwest.

There are three implications to this. The first is that in the short run, building Keystone will not drive up the prices faced by Midwestern consumers.

The second is that Midwestern refineries are significantly more profitable than refineries on the coasts.

The third is that if Keystone is not built, then refining capacity in the Midwest will rise, and eventually the Midwest will in fact enjoy cheaper gasoline than the rest of the country.

There are second-order implications about the desirability of whether U.S. oil exports should be allowed at all, but those will only be relevant when the U.S. achieves net crude oil balance. That is still some ways away, although it is now possible to imagine it happening with two decades ... perhaps much less.

Not refineries - refining capacity. Nobody's built a refinery in the U.S. in four decades. But billion-dollar investments to expand throughput happen all the time: overall refining capacity has risen at an annual average of around 1.2% (caveat: figure from memory) over those same four decades. That, in fact, is why nobody bothers to build greenfield any more.

In other words, if input prices were guaranteed to stay low in the Midwest for long periods, refining capacity would rise commensurately. But that's not the same thing as building a refinery.

Should I have written more clearly in the post? Apologies for the confusion.

I hope you'll forgive me for referring you to page 40 of Valero's financials. If all their operations looked like the mid-continent refineries, they would be investing like gangbusters.

Of course, on page 37 they say /exactly what I said above/: they do not expect the differential between WTI and Brent to last, because they expect pipeline projects to come on-line in the next two years.

The implication, of course, is that if those pipelines were not going to come on line, then Valero would be investing. Valero (like me) believes that they will, and therefore is not going to 30-year investments based on a temporary phenomenon.

Admittedly, the post above is a bit punchier. But I think it's worth saying that the Valero financials back my argument in both the numbers and the words.